After College: Understanding Investments

You have some money you want to invest—now what?

It's never too soon, even for students, to start investing money with the idea of someday buying a home or starting a business—or building a nest egg toward retirement.

Before you invest anything, you have a lot of homework to do: You need to understand not just the types of investments that are available, but the risks involved with each investment. Here are some themes to keep in mind:

Risk: Different types of investments have different degrees of risk for loss. Generally, the more risk you are willing to take, the greater your opportunity for potential returns. Unlike a deposit account at a bank, though, investments are not FDIC-insured, are not a deposit or other obligation of (or guaranteed by) a bank and are subject to investment risks, including possible loss of the principal amount invested. You could lose money with an investment.

Time: How long do you plan on investing? 10 years? 20 years? 30 years? Do you anticipate needing to get to your money before your investment matures? The longer you leave the money in your investments alone, the more opportunity you will give it to grow in the long run. Remember, too: Some investment types penalize you if you touch your money before the investment matures.

Diversification: Diversification means you spread your money among different investments to reduce risk. By doing this, you might be able to mitigate the effects of a meltdown within a particular investment type or industry. The more diversified your investments, the less any one investment can hurt you if it blows up. Please keep in mind that diversification and asset allocation don't ensure a profit or protect against loss in declining markets.

Liquidity: You may have heard people talk about having “liquid assets” or “being liquid.” Liquidity simply means being able to buy or sell an asset or security at its current value, which may be more or less than its original cost. Assets that can be easily bought or sold are known as liquid assets—which are good if you have concerns about ever needing to quickly access the money you're investing.

We've assembled some basic information about the most common forms of investments, but this is only the very beginning of the information you need to know before you invest. Before making any investment decision, you should speak with a financial advisor and weigh all the pros and cons. Remember: When it comes to investing, there's no such thing as a sure thing.

When you purchase an individual stock, you become part owner in a company. If the company does well, you might be able to sell your stock for a profit. With some stocks you may also get paid a dividend, which is simply a payment the company makes to its shareholders. However, if the company does poorly and its stock price falls, you may lose some or all of your investment.

Most stocks fall into these 2 main types:

Common: If you own a common stock, you're usually entitled to attend the company's annual meetings and you'll get one vote per share you own to elect board members, who oversee the major decisions made by the company's management. Your dividends, if any, are variable and not guaranteed and, if the company goes bankrupt, you will be paid last, after the creditors, bondholders and preferred shareholders.

Preferred: With preferred stocks, if the company does not do well, you will receive your dividends before common shareholders. However, you will not have the same voting rights as common stock holders, though this might vary depending on the company.

The most common way to purchase stocks is through an investment firm or brokerage. Fullservice brokerages offer advice on your investments and will manage your account for you. However, they can be pretty expensive. Discount brokerages won't give very much personal attention or advice, but they cost quite a bit less than a full-service brokerage

Another way to buy stocks is through your employer's direct stock purchase plan, if they offer one. These plans allow investors to buy shares of the company's stock directly from the company itself. Most have a minimum initial deposit but may be able to waive it if you agree to automatic monthly withdrawals from your checking or savings account. In some cases, you can even choose to have an amount taken directly from your paycheck.

When you purchase a bond, you're basically loaning money to a company or to the federal or local government. You're paid interest for the use of that money during a specified period of time, generally a few months to 30 years.

If you hang on to a bond until it matures, the issuer guarantees that you'll receive the original amount you paid, plus interest. Bonds may pay better interest than savings accounts or CDs, but you need to make sure you're loaning your money to a strong, secure company. If repayment is guaranteed only by the issuer, you could lose part or all of your bond investment if the issuer fails.

The most common types of bonds include:

Government bonds: These are issued by the federal or state government and include savings bonds and treasury bonds. These are relatively safe investments, but they yield lower interest rates than most other bond types.

Municipal bonds: Also known as munis, this type of bond is sold by local governments, such as cities and towns. They are often exempt from tax, which means you may pay no taxes on any interest you earn. Certain investors’ income may be subject to the federal alternative minimum tax (AMT), and state and local taxes may also apply.

Corporate bonds: Corporate bonds are issued by private and public corporations and are usually issued in multiples of $1,000 or $5,000. The interest payments you receive from corporate bonds are taxable and, unlike stocks, they don't give you an ownership interest in the company.

Convertible bonds: A convertible bond can be converted into shares of stock in the company that issues the bond, usually at a pre-determined ratio.

High-yield bonds: Also known as junk bonds, high-yield bonds are issued by organizations that don't qualify for investment-grade ratings by one of the leading credit rating agencies, meaning the issuer is considered to have a greater risk of not paying interest in a timely manner. These bonds pay higher interest rates, but are considered very risky.

You can purchase government bonds through a brokerage firm or, in some cases, directly from a government agency such as the Federal Reserve. If you're interested in purchasing other types of bonds, such as corporate bonds, you can do so through an investment firm or through a bond dealer.

It's important to note that investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Mutual funds are pools of money from different investors that are professionally managed. Mutual funds are typically invested in stocks or bonds, and you can usually buy mutual funds from an investment firm or directly from the fund. Mutual funds may offer less risk than individual stocks because they diversify your money by spreading it among multiple, professionally selected investments.

You can purchase mutual funds a few different ways. The least expensive way is directly through the fund company itself. Contact the fund company to request information and a prospectus for the fund or funds that you're interested in and ask what you need to do in order to make an investment in the fund. You can also purchase mutual funds from investment firms and brokerages. Keep in mind, though, that there will likely be some fees involved if you go through a third party to purchase mutual funds.

A 401(k) plan is a retirement plan that is funded with your before-tax salary contributions and often with a matching contribution from your employer.

Here's how the tax benefit portion of this savings plan works. Let's say you have a job making $50,000 a year and you elect to put $5,000 into your 401(k) plan. Only $45,000 would be recognized as income on that year's income tax return. You would not have to pay taxes on the $5,000 you invested into your retirement account until it is withdrawn. If your employer has a matching program in which they contribute money into your 401(k) as part of your benefits package, you are not taxed on that money until it is withdrawn.

Tax savings and contributions from your employer. Sounds like a no-brainer, right? You might be surprised by how many people choose not to participate in their company's 401(k) plan despite the obvious advantages. For those who do chose to contribute to a 401(k) plan, the IRS determines a maximum amount that can be contributed from your pre-tax salary. Those limits may change on an annual basis. For more information and to learn what the current amounts are, visit www.irs.gov.

Once there is money in your 401(k) account, you usually can't make any withdrawals before age 59 1/2, unless you have a special circumstance. If you do make an early withdrawal from your account, you will have to pay a penalty, generally 10%, for doing so. You will also lose the additional value that money would have gained over time.

As part of managing your 401(k) plan, you will typically be given several different investment options, including mutual funds and employer stock. You have the opportunity to decide how to divide your money among the available options. The choices you make could have a huge impact on the value of your 401(k), so you should do some research before you make those investment choices.

Even if you don't plan to be in a particular job for long, it makes sense to take advantage of any 401(k) option you have. When you leave a job, you can generally move your 401(k) into your new employer's plan or into a different IRA.footnote1

Interest

A fee charged for borrowing money. Also refers to money that a financial institution may pay individuals for keeping their money in an account there (such as an interest-bearing savings account).

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